The age of austerity is ending
Whisper it softly, but the age of government austerity is ending. It may seem an odd week to say this, what with the U.S. government preparing for indiscriminate budget cuts, a new fiscal crisis apparently brewing in Europe after the Italian election and David Cameron promising to “go further and faster in reducing the deficit” after the downgrade of Britain’s credit. But politics is sometimes a looking-glass world, in which things are the opposite of what they seem.
Discussing the outcome of Friday’s “sequestration” of U.S. government spending is best left to the month ahead, when we see how the public reacts to government cutbacks. But in Italy, Britain and the rest of Europe, this week’s events should help convince politicians and voters that efforts to reduce government borrowing, whether through public spending cuts or through tax hikes, are both politically suicidal and economically counterproductive.
In Italy, and therefore the entire euro zone, this shift is now almost certain. After the clear majority voted for politicians explicitly campaigning against austerity and what they presented as German economic bullying, further budget cuts or labor reforms in Italy are now off the agenda, if only because they would be literally impossible to implement. If Angela Merkel demands further budget cuts, tax hikes or labor reforms as a condition for supporting Italy’s membership of the euro, a majority of voters have given an unequivocal clear answer: Basta, enough is enough. Most Italians would rather leave the euro than accept any further austerity – and if Italy left the euro, total breakup of the single currency would follow with an inevitability that might not apply if the country exiting were Greece, Portugal or even Spain.
Merkel surely understands this, and she is determined to avoid a catastrophic euro crisis just before her own election in Germany on Sept. 22. She is therefore almost certain to heed Italian voters’ refusal to accept further tax hikes, budget cuts or labor reforms. From now on, the European Central Bank will have to offer its support to Italy without any tough pre-conditions. In fact, Italy can realistically be expected to make only one economic promise: to maintain the existing taxes and reform laws already legislated under Monti. That promise should be easy enough to keep, since Italy’s new parliament will be no more able to muster a majority for repealing old laws than for introducing new ones.
The European Commission, meanwhile, can move the fiscal goalposts in Italy’s favor. Once that precedent is set for Italy, similar flexibility should spread across the euro zone – and at that point the ECB would be able to offer effectively unconditional guarantees of financial support for all members of the euro zone, while Merkel and German voters turn a blind eye. Once investors work all this out, European financial markets can be expected to calm down and Italian politicians to return to what they know and love: plotting, backstabbing and Machiavellian intrigue.
Turning to Britain, we can see a similar paradox. Last Friday’s credit downgrade is actually likely to relieve austerity in two distinct ways. First, the downgrade should ensure that sterling remains weak, as the Bank of England and Treasury have long been praying. This will help, if only at the margin, to boost manufacturing and exports. More important, the downgrade will shake up British politics and economic policy.
Even before the downgrade, the pound had fallen back to the level of $1.51 where it traded in 2010 when Gordon Brown was still prime minister, but many investors viewed this as a temporary dip. Now the weakness of the pound is likely to prove longer-lasting, thanks largely to the credit downgrade.
The main reason for the pound’s unwelcome strength since the 2010 election was that Britain came to be viewed as a safe haven of financial and political stability in a sea of European chaos. As a result, vast amounts of flight capital poured into sterling. The credit downgrade will not automatically reverse these flows, but it will draw attention to a shift in British politics and policy that many international investors had until recently ignored: Britain is moving into a period of political, fiscal and monetary turbulence, just as political and financial conditions in the rest of Europe are becoming more stable.
With only two years to go before the next general election, the British economy shows few signs of sustained recovery, living standards are falling and the government is missing all the deficit and debt targets by which it asked to be judged. With other credit-rating agencies expected to follow last week’s downgrade from Moody’s, British voters will be repeatedly reminded of these failures. The governing coalition of Conservatives and Liberals, whose platforms agreed on almost nothing apart from the overriding necessity of deficit reduction, will be strained almost to the breaking point.
With an election just two budgets away and a radical new governor arriving at the Bank of England amid intense public expectations, a shift of policy away from austerity always seemed likely in the second half of 2013. Until last week, however, a major deterrent to policy U-turns was the fear of losing Britain’s triple-A credit rating. With that totem now demolished, Cameron has less reason than ever to persist with policies that are not only politically suicidal but economically counterproductive – and are coming to be recognized as such in Europe, as well as in America, Japan, China and indeed the world over. Things may not look that way just yet, but the age of fiscal austerity should soon be over.